Federal Income Tax exam summary Prof. Chirelstein.

Spring, 1998

QI. Possible characterizations are at least three:

(a) Sale for $1 million plus leaseback for 2 years for an advance rental payment of
$250,000 (or $125,000/yr ratably). Seller recognizes a § 1231 gain of $800,000 and has rent
deductions totaling $250,000; Jones includes $250,000 of rent in income and depreciates
property on a basis of $1 million.

(b) Just a sale of a future interest of $750,000. Seller's basis would be

$750,000/$1,000,000 x $200,000 = $150,000 and gain would therefore be $750 - $ 150=
$600,000. No rental deduction for S but amortization totaling $50,000 over the 2-year period; no
rental inclusion for J, and a basis for J of $750 after 2 years.

(c) Loan of $750 repayable with $1 million property value at the end of 2 years; gain to S
of $1 million minus adjusted basis on repayment in yr 2; ratable interest deduction of $1 25/yr to
S and ratable inclusion of $125/yr by J. J's basis $1 million after 2 years.

Alternative (b) would mean a shift from J to S (which apparently has offsetting losses) of
$250,000 of ordinary rent, plus a shift from S to J of $250,000 of gain that would otherwise be
taxable to S and recoverable by J through later depreciation. In effect, S would be "selling" J the
right to defer $250,000 of income from yrs 1 and 2 to much later periods, making the deal more
attractive to J while being harmless to S-- all at the Treasury's expense.

Alt. (c) is probably the economically correct answer, but Alt. (a) is easier to come by,
judicially.

QII. Different outcomes can be argued for, as follows:

(a) No income tax consequences whatever to Bloom or Molly. Bloom's interest in the
trust includes a right to the income for life plus a power to eliminate Molly's secondary life estate
and advance Stephen's remainder (or not to do so) and thus to pick and choose between the two.
All that, arguably, adds up to continued ownership of the trust property (citing Clifford or what-
have-you). Certainly a right to revoke would be so treated, wouldn't it? Maybe a retained life
estate together with a power to pick-and-choose would be similarly regarded.
Viewed thus, Bloom now sells a remainder to Stephen for $500,000. The trust property
hasn't appreciated, so the $500 received would not exceed Bloom's allocable basis for the
remainder interest sold; hence no gain or loss to Bloom. The $250,000 paid over to Molly would
simply represent the completion of a nontaxable gift to her. Stephen would have a basis of $500
for his purchased remainder and he would presumably have ordinary income (on analogy to a
discount bond; see Jones case) of $500,000 ($1 million - $500,000) when the trust terminates and
he receives the entire trust corpus.

(b) In the alternative, since he can't recapture the property for himself, maybe treat
Bloom's gift of future interests as complete when made. Then, capital gain of $250 to Molly
under § 1001(e) on the theory that what she's done is to sell a "term interest" to Stephen. But did
she really sell a "term interest" as defined in § 1001(e)(2), or was she merely being paid for the
settlement of a legal claim against Bloom? If the latter, where's the "capital asset"? Etc.
As to Bloom, how do we classify a "power" under § 1221? Should we regard that power
as an "encumbrance" and hence a capital asset, citing Ferrer, with a basis equal to fair market
value (noting again that the bond hasn't appreciated)? Or, since not within the definition of a
"term interest" in § 1001(e), should we view it as "ordinary" and as having a zero-basis? Also
etc.
As to Stephen, if treated as the purchaser of a life estate, he'd be entitled to amortize his
$500 cost over Molly's life expectancy following Bloom's death, reporting only the yearly excess
as ordinary income. On termination of the "estate per autre vie" (i.e., Molly's actuarial interest),
Stephen as remainderman would get a basis of $1 million for the bond.

Alt. (a) obviously favors Bloom and Molly and hits Stephen with a lot of ordinary income at
Bloom's death. Alt. (b) relieves Stephen by letting him spread such income over Molly's life
expectancy, but at the cost (probably) of a capital gain tax to Bloom and Molly. Alt. (b) is pretty
messy, though arguably more consistent with the Gavit scheme and with § 1001(e), while the
outcomes under Alt. (a) are at least less problematic. Thus, under Alt (a), Bloom continues to be
taxed at ordinary rates on his own trust income, Molly gets an excludable gift, and Stephen,
having purchased a "stripped remainder", is ultimately taxed on what amounts to an interest
accrual when the trust terminates (see, though not actually applicable, § 1286).

Everything seems to depend on how you calibrate Bloom's "ownership" status, which is probably
the issue with which one's answer should begin.

QIII. On net, there has to be $55 of recoverable outlay. Symmetrical outcomes seem to be called
for. Either

(a) Green deducts $75 as a repair expense, while M has $75 of ordinary income (e.g.,
lump-sum rent) plus a capital expenditure and basis of $55 for the drainage facility; or

(b) Green has a capital expenditure of $75 (e.g., purchase price of an "improvement"),
while M has net ordinary income of only $20 and a zero basis for the drainage facility (having
deducted the $55 cost as a repair).

Neither outcome seems quite fair since the drainage facility apparently adds no value to
either property. Possibly, then, we might combine (a) and (b) by giving both taxpayers a repair
deduction. The Commissioner, however, is likely to take a stakeholder's position, insisting that
one or the other capitalize the outlay -- as would, after all, be the case if the two properties, farm
and drive-in, belonged to a single firm (Coase?). In view of the well-known precedents --
Midland and Mt. Morris itself -- Alt. (a) seems the more likely to prevail.